Deferred Tax under Ind AS On Exchange Differences Capitalised

Background

Under Indian GAAP, Para 46A of AS
11 The Effects of Changes in Foreign Exchange Rates, allowed an option
to companies to capitalise exchange differences arising on borrowings for
acquisition of fixed assets. The exchange differences arising on reporting of
long-term foreign currency monetary items at rates different from those at
which they were initially recorded during the period, or reported in previous
financial statements, insofar as they related to the acquisition of a
depreciable capital asset, can be added to or deducted from the cost of the
asset and shall be depreciated over the balance life of the asset.

Paragraph D13AA of Ind AS 101 First
Time Adoption of Ind AS provides an option on first time adoption of Ind
AS, to continue with the above accounting. A first-time adopter may continue
the policy adopted for accounting for exchange differences arising from
translation of long-term foreign currency monetary items recognised in the
financial statements for the period ending immediately before the beginning of
the first Ind AS financial reporting.

Paragraph 15 of Ind-AS 12 Income
Taxes states as follows: A deferred tax liability shall be recognised for
all taxable temporary differences, except to the extent that the deferred tax
liability arises from:

a)  the initial recognition of
goodwill; or

b)  the initial recognition of an
asset or liability in a transaction which:

i.   is not a business combination;
and

ii.  at the time of the transaction,
affects neither accounting profit nor taxable
profit (tax loss).

The exchange differences on
foreign currency borrowings used to purchase assets indigenously are not
allowed as deduction under the Income-tax Act either by way of depreciation or
otherwise. Under Income Tax Act, such expenditure is treated as capital
expenditure. Section 43A of the Income-tax Act contains special provision to
provide for depreciation allowance to the assessee in respect of imported
capital assets whose actual cost is affected by the changes in the exchange
rate. However, section 43A does not allow similar benefit for assets purchased
indigenously out of foreign exchange borrowings.

Issue

A company chooses to continue with
the option of capitalising exchange differences. On first time adoption of Ind
AS and thereafter, whether the Company should create deferred taxes on the
exchange differences capitalised?

Author’s Response

Paragraph 15 requires that no
deferred taxes are recognised on temporary differences that arise on initial
recognition of an asset or liability, which neither affects accounting profit
nor taxable profit. This is commonly referred to as ‘Initial recognition
exception (IRE).’ When IRE applies, deferred taxes are neither recognised
initially nor subsequently as the carrying amount of the asset is depreciated
or impaired.

There is no precise guidance in
the standards on this issue. Based on the above requirements of Ind AS, the
following two views need to be examined:

View 1: IRE exception does not apply and deferred tax needs to
be recognised

–   IRE applies
only at the time of initial recognition of an asset or liability. In this case,
difference between tax base and carrying amount is arising subsequent to
initial recognition of the asset. Hence, IRE does not apply and deferred tax
needs to be recognised on amount of exchange differences capitalised (both
increases and decreases) to the asset in this manner. The corresponding
adjustment is made to P&L. With regard to exchange difference arising
before the transition date, adjustment is made to retained earnings. The
reversal of deferred tax will be recognised in P&L as the exchange
difference is depreciated.

–  Since
exchange differences do not have an identity independent of the underlying
asset, IRE will not apply (since it is not a new asset) and deferred tax will
need to be created on temporary differences attributable to exchange difference
adjustments.

–   An analogy
can be drawn to revaluation reserve (an item that too does not have an identity
independent of the underlying asset) on which Ind AS 12 specifically requires
creation of deferred taxes. A deferred tax liability is created on the
revaluation of fixed asset. Subsequently, the depreciation on the revalued
portion is debited to P&L. Recoupment out of revaluation reserve is not permitted
under Ind AS. As and when depreciation on revaluation is debited to P&L,
the deferred tax liability is debited and a tax credit is taken to P&L.

–  An analogy
can also be drawn from land indexation benefit. A temporary difference is
created between book value and tax value of land, because of indexation
benefits allowed under the Income-tax Act for land. On such indexation amounts,
a deferred tax asset is created subject to the probability criterion being met.

–   View 1 is
also supported by the fact that the additional capitaliation is not reflected
as a separate asset in the accounting records of the Company (for example, the
fixed asset register).

View 2: IRE exception applies and deferred taxes need not be
recognised

–  When the
company adjusts exchange differences to the carrying amount of the asset, the
entry passed is Debit Asset, Credit Borrowings – that affects neither taxable
profit nor accounting profit. One may argue that each addition to the cost of
asset is in substance a new asset. This requires IRE to be applied at the time
of each capitalisation (which may include increase to the fixed assets due to
exchange loss or decreases to the fixed assets if there is exchange gain).
Consequently, IRE applies and no deferred tax should be recognised on difference
between the carrying amount and the tax base of the asset arising due to
capitalisation of exchange differences. The reversal of this portion of
exchange differences will also have no impact.

–   Support for
view 2 can be drawn from the requirement of paragraph 46A to depreciate each
period’s capitalisation over the remaining useful life of the underlying asset.
In other words, the additional capitalisation is treated as a separate item to
be depreciated over the remaining useful life of the asset. If it was treated
as the original asset itself, there would be a need to provide for depreciation
on a catch up basis, as if the exchange difference capitalisation had happened
immediately on purchase of the asset.

–   View 2 can
also be articulated differently. 
Assuming that the capitalisation requirements were slightly tweaked to
require the exchange difference to be capitalised each time as a separate
intangible item, the IRE exception would certainly apply in that case.

Conclusion